How to Evaluate Investments and their Attributes?

Investment Analysis is simply the process of evaluating an investment in each attribute of investments. Evaluation of investment involves evaluating the attributes of investments. Return, risk, liquidity, tax benefits, and convenience are the key attributes taken into consideration before investing in any particular type of investment. Investments are evaluated to decide or choose the right investment.

Investments are an integral part of any business. Every company has investments in many forms whether they are in projects or assets. Income from investments has a direct impact on the profitability of the company and it is one of the primary responsibilities of a finance manager to effectively invest the company’s funds in optimizing its profits.

Funds are invested for short term or long term depending on the availability or idleness of funds. To explain further, sometimes company’s concern is to do the expansion and therefore it looks out for both acquisition and investment of funds in profitable projects or else it uses its idle cash to invest in other assets or other companies through equity shareholding etc. On the contrary, sometimes in seasonal businesses, the excess of working capital is invested in short-term investment options mostly consists of money market instruments.

Investment Attributes

In essence, for effective investment, investment alternatives need to be analyzed or evaluated. Following attributes of investments can be taken into consideration for evaluating the investments.

Return

A good rate of return on an investment is the first and the foremost condition for effective investment. The rate of return is the ratio of the sum of annual income and price appreciation for the purchasing price of the asset or investment.

Let us illustrate it with an example. Suppose a person has invested in equity shares of a company A at the price of Rs. 100. During the year, company A pays a dividend to its shareholders of Rs. 10 and price of the share at the end of the year are Rs. 115.

Rate of Return = {10 + (115 – 100)}/ 100 = 0.25 or 25%.

For more in-depth analysis, the rate of return can be broken into two parts: Current Yield and Capital Gain/Loss. In the current example,

Rate of Return = 10% + 15% = 25%

Here, the current yield is 10% and capital gain is 15%. Current yield is more stable compared to capital gains. Capital appreciation may not always be there. In bad markets, it is quite possible to have capital loss as well.

Annual Income

(Ending Price – Purchasing Price)

Rate of Return

=

—————–

+

————————————–

Purchasing Price

Purchasing Price

(Current Yield)

(Capital Gain or Loss)

Risk

The rate of return on different investment options varies a lot. Remember the famous quote, ‘More the risk and more the profits’. It is a general phenomenon that more return is expected out of a high-risk investment. Risk means the uncertainty of returns. Statistically, the risk is judged based on parameters like variance, standard deviation, and beta. More a security deviate from its expected outcomes, a risk is considered to be high. Challenge for a finance manager while investing funds is to achieve high returns on investments while keeping the risk at lowest possible levels.

Liquidity

Liquidity means marketability of an investment. For example, equity shares of a big company can be easily liquidated in the stock markets. On the other hand, money invested in an asset (machinery) cannot be liquidated as easily as the equity share. An investment is considered highly marketable or liquid it can be easily transacted with low transaction cost and low price variation. A finance manager looks for more liquid investments when the funds are available for the short period. Liquidity is always given a preference because it helps the managers remain flexible.

Tax Benefits

It is true for some investments and not for all. Most of the countries have tax incentives for particular investments except tax-free countries. So, for investments which have tax benefits, it is an important consideration because taxes form a major part of their expenses.

Convenience

Convenience means ease of investment. When an investment can be made and looked after easily, we consider it as convenient investing. For example, it is easy to invest in equity shares compared to real estate because real estate involves a lot of documentation and legal requirements.

How to Evaluate and Analyze Investments to Check Viability?

Investment analysis and appraisal are one of the primary jobs of finance managers. It evaluates new investment opportunities for its physical and financial viability. Most important of all is the financial viability because financial survival has to be the first goal for any firm to achieve any other goal.

Investment analysis and appraisal is a stepwise decision-making the process to assist managers in deciding about the acceptance or rejection of a project. Essentially, it analyzes the cash flows and other factors of the project to evaluate the financial feasibility. We can follow the step by step process as mentioned below:

Investment Analysis and Appraisal

Estimate the Cash Flows

After coming across an investment project, the first thing that a manager should do is to estimate the cash flows of the project. It is like a base of the building which should be very strong. Estimation of cash flow should be as accurate as possible as they become the foundation for all the further steps of this process.

For example, let’s assume we will have following cash flows in a project with the initial investment of $30,000.

Year

1

2

3

4

5

Cash Flows

10000

11000

13000

15000

15500

Appropriate Opportunity Cost of Capital

Next most important thing is to discover an appropriate opportunity cost of capital. Why should opportunity cost of capital be found? It is simply because we will compare the current investment returns based on the returns on next best alternative investment opportunity.

The opportunity cost of capital is that rate of return which the investor can earn if he does not invest in this investment. This evaluation is also equally important just like the estimation of cash flows. For achieving wealth maximization for the investors, it is important to take projects that earn better returns than what they are earning currently. Here we are in the race for finding correct current returns of the investors.

Continuing the same example, let’s assume that the investors are normal public and if the cash is distributed to them as the dividend, they will invest in fixed deposits at the rate of 12% per annum. So, this rate becomes the opportunity cost for the investors.

Calculate Discounted Cash Flows

This step will not have to do any more market research. In this step, we will simply use the opportunity cost of capital and discount the cash flows estimated in step 1.

Years

1

2

3

4

5

Cash Flows

10,000

11,000

13,000

15,000

15,500

*Discounted Cash Flows @ 12%

8,929

8,769

9,253

9,533

8,795

Present Value

In this step, we will add all the discounted cash flows to find the present value of all future cash flows. The present value in our example is coming to be $ 45,279.

Net Present Value

Now when we know the present value of the future cash flows, we can compare them with the present investment which we have to make i.e. $40,000. The present value of all the estimated cash flows is more by $5,279. This means that the project is worth doing.

Understanding it in a different way, we can conclude that we are getting $45,279 for a payment of $40,000. $5279 is the reward of all the hard work which the organization will do over the life of the project to implement and execute it successfully.

We have used the investment analysis tool of net present value but other tools and techniques also exist i.e. Internal Rate of Return, Profitability Index etc. We believe that the net present value is the best method of investment analysis compared to all other methods. Refer our article on “Why Net Present Value is the Best Measure for Investment Appraisal?”

About The Author

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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